Guidelines for economic analysis ADB

GUIDELINES
FOR THE
ECONOMIC ANALYSIS
OF PROJECTS
Economics and Development Resource Center
February 1997

FOREWORD
A Bank Task Force on Project Quality established in 1993 considered several means of
enhancing the effectiveness of Bank operations, in conjunction with borrowing member
countries. A number of steps were identified to improve the quality of projects at the
preparation stage as well as at the implementation stage. To this end, an Interdepartmental
Working Group was established to reconsider the nature and role of the economic analysis of
projects, and in particular to review the existing guidelines for project economic analysis, as a
means of enhancing project quality “at entry”. This review has led to these new Guidelines for
the Economic Analysis of Projects.
Bank staff and consultants are required to undertake economic analysis of Bank loan
projects in a relatively uniform way. Guidelines for this purpose were issued last in 1987.
Several factors have come together to make it necessary to produce this new general guidelines.
First, the Asian Development Bank has reconsidered its own priorities. A new set of
objectives for classifying Bank projects has been established, resulting in a greater emphasis on
projects producing nontraded outputs that meet people’s needs directly. Second, the source of
finance for many types of project is changing with a greater role for the private sector. Greater
emphasis therefore needs to be placed on the appropriate roles of the public and private
sectors in the provision of goods and services before specific project proposals are brought
forward for analysis. Third, Bank staff and consultants now have to deal with a broader range
of issues than before. This can be summarized under the title of sustainability, the realization
that the economic benefits of projects will not fully materialize unless attention is also paid to
cost recovery and financial sustainability, to environmental effects and to the distributional
effects of projects. Finally, the subject matter of project economic analysis has itself undergone
some change. Greater attention is now paid to the broader aspects of economic analysis, the
way project alternatives are identified and assessed, the treatment of uncertainty, and the
policy context in which projects are undertaken.
These new guidelines have been prepared by the Project Economic Evaluation
Division of the Economics and Development Resource Center, in consultation with the
Interdepartmental Working Group and after comments from staff in the Bank’s Projects
Departments. They outline the principles upon which the economic analysis of projects should
be based. The appendices provide illustrations of their application. The guidelines provide the
basis for quantifying and valuing project costs and benefits where all relevant data are
available. However, it may not always be possible to quantify and value all the costs and
benefits of a particular project. The guidelines provide for the ideal situation to which Bank
practice should aspire.

Whilst continuing to focus on economic viability, or on economic effectiveness
of alternatives where benefits cannot be valued, as the key criterion for assessing Bank loans,
these guidelines now provide a more integrated approach to the economic analysis of projects.
Not every form of analysis contained in these guidelines will be equally applicable to every
project. Projects Departments will need to take a decision early in project processing about the
forms of economic analysis appropriate to a particular project.
These guidelines are issued to assist Bank staff and consultants to answer the basic
economic questions that need to be asked about any of its project loans. It is hoped that
through their application the underlying purpose of enhancing project quality will be better
served.
VISHVANATH V. DESAI
Director and Chief Economist
Economics and Development Resource Center
January 1997

ABBREVIATIONS
AIEC - average incremental economic cost
AIFC - average incremental financial cost
BCR - benefit-cost ratio
BOOT - build-own-operate-transfer
BPEV - border price equivalent value
CEA - cost effectiveness analysis
CF - conversion factor
CIF - cost insurance freight
CS - consumer surplus
DMC - developing member county
DMP - domestic market price
DP - demand price
DRC - domestic resource cost
EAC - effective assistance coefficient
EAR - effective assistance ratio
EC - economic cost
EDR - equalizing discount rate
EIA - environmental impact assessment
EIRR - economic internal rate of return
ENPV - economic net present value
EOCK - economic opportunity cost of capital
EP - economic price
EQDR - equalizing discount rate
FIRR - financial internal rate of return
FNPV - financial net present value
FOB - free on board
FP - financial price
GEB - gross economic benefit
HDTP - handling, distribution, transport, processing
HLD - healthy life day
IRR - internal rate of return
LIBOR - London interbank offer rate
NEB - net economic benefit
NFB - net financial benefit
NGO - nongovernmental organization
NOER - nominal official exchange rate
NPV - net present value
O&M - operation & maintenance

OCR - ordinary capital resources
OER - official exchange rate
PAR - project assistance ratio
PAC - project assistance coefficient
PIR - poverty impact ratio
PV - present value
PVC - present value of cost
ROER - real official exchange rate
SCF - standard or average conversion factor
SER - shadow exchange rate
SERF - shadow exchange rate factor
SI - sensitivity indicator
SP - supply price
SV - switching value
SWR - shadow wage rate
SWRF - shadow wage rate factor
UFW - unaccounted for water
WMP - world market price
WTA - willingness to accept
WTP - willingness to pay

ACKNOWLEDGMENTS
These guidelines were produced as a joint effort by several persons. The overall
structure and content of the guidelines were subject to external review at different stages by
William Ward and J. Price Gittinger. However, the text of the guidelines was written by
members of staff of the Project Economic Evaluation Division of the Bank’s Economic and
Development Resource Center. Stephen Curry and George Whitlam drafted the main text and
the majority of the appendixes, while selected appendixes were provided by Anneli Lagman,
Bo Lin, Rita Nangia, and Arlene Tadle. The document benefited several times from the
comments of Jungsoo Lee, Assistant Chief Economist, Project Economic Evaluation Division,
and its preparation was undertaken with the encouragement of Vishvanath Desai, Director
and Chief Economist.
Drafts of the guidelines were subject to several internal reviews, first by an
interdepartmental working group chaired by Jungsoo Lee, and subsequently by the Directors
and staff of operational departments. Reviews of earlier drafts were provided by Piyasena
Abeygunawardena, Ifzal Ali, Nihal Amerasinghe, Peter Darjes, David Edwards, Preminda
Fernando, Morimitsu Inaba, Thomas Jones III, Bindu Lohani, Bruce Murray, Lester Neumann,
Gene Owens, Frank Polman, Narhari Rao, William Staub, Phiphit Suphaphiphat, Etienne Van
De Walle, Jean-Pierre Verbiest, and Chi-Nang Wong of the interdepartmental working group.
Subsequent comments from operational departments were received particularly from
Elisabetta Capannelli, Bruce Carrad, Brian Fawcett, Kazi Jalal, Toshio Kondo, Loh Ai Tee,
Takashi Matsuo, Mark Mitchell, Patricia Moser, Eustace Nonis, and Frederick Roche.
The preparation of the manuscript was undertaken through many drafts and revisions
by Digna Real. It was edited by Judith Banning and processed through the several stages of
production by Virginita Capulong, Marcelia Garcia and Regina Sibal. Assistance with printing
was provided by Victor Angeles and Raveendranath Rajan.
This version of the guidelines, produced particularly for distribution outside the Bank,
is intended as a means of creating a better understanding of the purposes and content of the
economic analysis of projects by several groups of users. It is hoped that a consistent
application of principles will develop between Government officials from borrowing
countries, consultants employed by the Bank in project preparation, and Bank staff. Prior
acknowledgment, therefore, is given to the users of these guidelines who have the joint task of
improving the quality of Bank-assisted projects.

CONTENTS
Page
I. INTRODUCTION 1
II. BACKGROUND 1
III. THE ECONOMIC RATIONALE OF A PROJECT 2
IV. MACROECONOMIC AND SECTORAL CONTEXT 4
V. AN INTEGRATED APPROACH TO ECONOMIC ANALYSIS 5
A. Scope of Economic Analysis 5
B. The Project Framework 7
C. Financial and Economic Analysis 8
VI. IDENTIFICATION AND QUANTIFICATION OF
COSTS AND BENEFITS 10
A. General 10
B. Identification and Quantification of Benefits 11
C. Identification and Quantification of Costs 12
VII. VALUATION OF ECONOMIC COSTS AND BENEFITS 14
A. General Considerations 14
B. Role of World Prices 16
C. Economic Prices of Traded Goods and Services 18
D. Economic Prices of Nontraded Goods and Services 19
E. The Economic Price of Labor 21
F. The Economic Price of Land 23
G. Bringing Economic Prices to a Common Base 25
H. Conversion Factors 27
I. Economic Viability: A Procedure 29
VIII. LARGE PROJECTS, LINKAGES, AND NATIONAL AFFORDABILITY 30
IX. LEAST-COST AND COST-EFFECTIVE ANALYSIS 31

Page
X. INVESTMENT CRITERIA: ECONOMIC VIABILITY 34
A. Project Decisions 34
B. Choosing Between Alternative When Benefits are Not Valued 34
C. Choosing Between Alternatives When Benefits are Valued 35
D. Testing the Economic Viability of the Best Alternative 36
E. The Chosen Discount Rate 37
F. Project Investments and the Budget 37
XI. DISCOUNT RATE 37
XII. UNCERTAINTY: SENSITIVITY AND RISK ANALYSIS 39
XIII. SUSTAINABILITY OF PROJECT EFFECTS 40
A. Financial Sustainability 41
B. Environmental Sustainability 44
XIV. DISTRIBUTION OF PROJECT EFFECTS 46
XV. PROJECTS AND POLICIES 48
A. Comparing Financial and Economic Prices 49
B. Effective Protection or Effective Assistance 50
C. The Real Exchange Rate 51
APPENDIXES 52

FIGURE/TABLES
Page
Figure 1 Scope of Economic Analysis 7
Table 1 Basis of Economic Valuation of Project Outputs and Inputs 16
Table 2 Valuation of Main Project Outputs and Inputs 17
Table 3 Border Price Equivalent Value Adjustments 18
Table 4 Specific Conversion Factors from Cost Breakdowns 29

APPENDIXES
Page
1 Key Questions for the Economic Analysis of Projects 52
2 Project Economic Rationale: Market and Nonmarket Failures 56
3 The Project Framework 59
4 Identification and Measurement of Consumer Surplus 62
5 Treatment of Working Capital 66
6 Depletion Premium 69
7 The Use of Constant Prices in the Economic Analysis of Projects 73
8 General Methodology for Building Up Project Statements 76
9 Economic Valuation of Project Output and Input 80
10 Economic Price of Traded Goods and Services 86
11 Valuation of Nontraded Outputs and Inputs 94
12 Shadow Wage Rate and the Shadow Wage Rate Factor 107
13 The Economic Price of Land 110
14 Treatment of Resettlement Components of Projects 114
15 Calculating Economic Prices at the Domestic Market Price
or World Market Price Levels 116
16 Estimating the Shadow Exchange Rate Factor and the Standard
(or Average) Conversion Factor 122
17 Example of an Economic Rate of Return: An Irrigation
Rehabilitation Project 131

Effect on Net Foreign Exchange and Budget Flows: An Example 135
19 Least-Cost Analysis and Choosing Between Alternatives 140
20 Estimating the Economic Opportunity Cost of Capital 145
21 The Treatment of Uncertainty in the Economic Analysis of
Projects: Sensitivity and Risk Analysis 149
22 User Charges, Cost Recovery, and Demand Management:
An Example for Piped Water 159
23 Financial Returns to Project Participants: An Illustration 162
24 Economic Valuation of Environmental Impacts 167
25 Distribution of Project Effects 174
26 Impact on Poverty Reduction 179
27 Difference Between Economic and Financial Prices 183
28 Use of Economic Prices in Measuring Effective Protection 186
29 Exchange Rate Issues in Project Analysis 189

GUIDELINES FOR THE ECONOMIC ANALYSIS OF PROJECTS 1
GUIDELINES FOR THE ECONOMIC ANALYSIS OF PROJECTS
I. INTRODUCTION
1. These guidelines provide a general approach for the economic analysis of projects for
application by the Asian Development Bank.1
While the guidelines focus on the objective of
maximizing net output or income, which is often referred to as the “economic” of “efficiency”
objective, they do so in a broad manner to ensure consistency with the Bank’s focus on
• the social sectors and the environment, and
• greater project and program support to develop institutions and organizations that
facilitate economically efficient market activity in the Bank’s developing member
countries.
2. The economic analysis of projects includes an assessment of the sustainability of
project effects to ensure that
• the project provides sufficient incentives for producers,
• sufficient funds are available to maintain project operations,
• the least cost means of providing the project benefits is used,
• the distribution of project benefits and costs is consistent with project objectives, and
• environment effects are included in the analysis (see Appendix 1).
II. BACKGROUND
3. Several factors have combined in recent years to change the context within which
Bank lending operations occur. The Report of the Task Force on Improving Project Quality
(1994) recommended that the Bank’s guidelines and procedures for the economic analysis of
projects be reviewed with the aim of strengthening project quality. At the same time, the
Medium-Term Strategic Framework adopted by the Bank requires greater emphasis to be
placed on social and environmental concerns. This has resulted in the need to widen the scope
of economic analysis to account more fully for nonmarket benefits and costs.
4. Other factors include evolving changes in the theory and practice of development
and the role of the public sector; the related shift toward stronger support for environmental
sustainability; and greater emphasis on organizational and institutional change and provision
of social, legal, and institutional infrastructure to facilitate private economic activity.
1
This guidelines are a revision of the previous edition published in 1987. The revision draws on research
undertaken by the Bank and other multilateral lending institutions.

2 GUIDELINES FOR THE ECONOMIC ANALYSIS OF PROJECTS
5. The application of economic logic to the identification of appropriate investment
operations and to the economic analysis of such projects derives from the prevailing views and
theories on economic development, and on the most effective role for government in the
economy. During the 1980s and 1990s, both of these bodies of theory experienced major and
continuing change. Development is now seen less as a process of transferring physical capital,
and more as assisting in human capital and institutional development. In economic
management, government is seen as playing more of a facilitative, rather than a command and
control, role. In particular, direct investment in government activities in industry, finance, and
agriculture takes a decreasing share of the Bank’s loan portfolio. Instead, Bank investment in
the form of loans, and credits to these sectors is increasingly directed at facilitating private
sector development.
6. The view that has emerged is that the facilitative role of government includes four
primary sets of activities:
• providing the institutional framework within which market-based transactions can
expand and appropriate government investments can be rationally made, such as,
political stability, commercial codes, legal systems, budgeting and control systems,
consumer protection, and respect for property;
• provision of an economic environment in which private investment can expand
efficiently and equitably, for example, price and exchange rate stability, neutrality
between sectors, access to global financial and capital markets, and access to export
and import markets;
• development and maintenance of human capital and technological capability, for
instance, an educated and healthy workforce, access to technology, and ability to
adopt and adapt; and
• provision and maintenance of economic and social infrastructure, such as transport,
communications, and health and welfare systems.
7. At the same time; project planning and project economics are now affected by
environmental issues; various aspects of sustainability, including those of a financial,
environmental, economic, social, and political nature; equitability; participation; and
governance, including the role of women and nongovernment organizations in development.
Economic analysis must facilitate the analysis of these additional issues whilst maintaining the
basic focus on economic viability.
III. THE ECONOMIC RATIONALE OF A PROJECT
8. The application of economic logic should occur early in the project cycle, rather than
simply at the appraisal stage. It should lead the analyst to ask whether the investment
operation being analyzed represents an appropriate role for government or whether a policy
change or institutional change might be broader reaching and more sustainable than a

proposed physical investment. The analysis of investment operations and the analysis of
policy-based alternatives can flow from the application of the same forms of economic logic.
9. The inadequacy of markets to produce what society wants provides the main rationale
for Bank operations. Where financial returns are less than cost recovery, or revenues are
nominal or nonexistent, there is a case for financing public projects. Because external benefits
and costs are not a part of financial production decisions, too little output will tend to be
produced where externalities are net benefits, and too much where they are net costs (see
Appendix 2).
10. Many goods and services are still produced in relatively monopolized markets, both
by the public sector and by the private sector. Bank assistance should be combined with
development of a legal and regulatory framework that limits the effects of monopoly
structures. The extent to which competitive market structures can be created or simulated
depends on transactions costs. Transactions costs include the costs of negotiating and
enforcing contracts, and the costs of collecting charges for goods and services provided. The
Bank can assist with the introduction of new technologies and institutional arrangements
which reduce transactions costs and increase accountability. In some sectors, the Bank will
therefore achieve a longer term aim of ensuring sustainable private production of both private
goods and public goods.
11. The Bank seeks to provide finance primarily for public and near-public goods, and for
those elements, such as roads, irrigation systems or enterprise restructuring, which help to
create the conditions under which a larger number of goods can be produced as private goods.
The two common criteria used to distinguish between public and private goods are
• subtractability—how much the consumption of a good or service by one person
subtracts from the ability of others to use the good or service; and
• excludability—the extent to which a potential user can be excluded if the user does not
meet conditions set by the supplier.
The Bank is also involved in reducing public bads such as environmental costs or poverty, and
in funding some private sector developments where they can play a catalytic or demonstration
role.
12. Bank operations must also cope with the consequences of nonmarket failure. Many
projects, both private and public, underperform because they are not implemented and
operated effectively and because the project benefits are captured by some groups, especially
the nonpoor, and not by others. Nonmarket failure helps to explain why projects often yield
higher costs and lower benefits than those forecast at appraisal. Bank projects and operations
can reduce nonmarket failure through capacity building for strengthening organizational
capacity, and for restructuring institutional roles in a sector.

IV. MACROECONOMIC AND SECTORAL CONTEXT
13. Project proposals should be derived from, and placed in the context of, broader
development objectives. These objectives may be explicitly stated in a government plan
document, or implicitly given through a public investment program. They will form the basis of
the Country Operational Strategy Study. A statement should be given of the main
development objectives of a country to which a proposed project will contribute. This
statement is separate from the classification of projects according to the Bank’s own system of
priorities, and includes the time period in which specific objectives are to be achieved or
programs of investment are to be implemented.
14. There will be constraints to the achievement of development objectives and
implementation of sector programs. At the sector level
• forecasts should be provided of future demands or needs for the type of output to be
produced;
• existing sources of supply, the costs of supply, and intended investments should be
outlined;
• a statement should be provided of the contribution of the proposed project to
meeting sector demands or needs, and any cost reduction or technology innovation it
may contribute; and
• a statement should be provided of the extent of direct government involvement as a
supplier and the extent of government subsidy to the sector.
15. Many investments will work well only if there are complementary investments in
related sectors or activities. For example, for an irrigation project to raise agricultural output,
the appraisal report must elaborate the necessary extra requirements for transport and
processing. Projects to improve urban services should consider the capacity of the existing
systems to deliver additional power and water. Potential constraints in supplies, whether they
can be overcome, and the necessary timing of complementary investments, must be
considered.
16. Because a project takes place within a given macroeconomic and sector context, an
investment project can be seen as an incremental change to an existing structure. In fact, the
context may be more important than the project itself. Moreover, a project that is financially
sound within one sector and macroeconomic context may be financially unsound in another.
Thus policy changes may be as important as the physical investment to the achievement of
development objectives.
17. The macroeconomic and sector context will result in differences between financial
and economic prices. The policy context that affects financial and economic prices can be
analyzed on a country basis by determining

• how levels for the key macroeconomic parameters—exchange rate, interest rates, and
wages—are determined;
• the impact of microeconomic policies, such as import quotas, rationing schemes, and
special financial incentives, on a particular investment;
• which border policies, such as import duties and export subsidies, will affect project
outputs and inputs and how; and
• what are the existing market structures, such as the degree of monopoly supply and
pricing for public utilities and other inputs, and the degree of competition for project
outputs.
18. Brief statements on each of these four factors will focus attention on the
macroeconomic and sector framework. Where any of the factors are deemed very significant,
then the efficiency of project investments is likely to be reduced as consumers and suppliers
respond to distorted prices. In addition, substantial differences between financial and
economic prices as a result of any of these four factors can be a prelude to policy changes that
increase the risk of project investments. Therefore, the statement of the macroeconomic and
sector context should be accompanied by a statement on whether the intended investment
project and associated policy dialogue are likely to facilitate adjustments in the framework or are
likely to bolster resistance to change.
V. AN INTEGRATED APPROACH TO ECONOMIC ANALYSIS
A. Scope of Economic Analysis
19. The purpose of the economic analysis of projects is to bring about a better allocation
of resources, leading to enhanced incomes for investment or consumption. For a directly
productive project, where the output is sold in a relatively competitive environment, choices
are made within the economy to ensure that projects selected for investment meet a minimum
standard for resource generation and to weed out those projects that do not. For an indirectly
productive project, where the output is not sold in a competitive environment, choices are
made within the project between different means of achieving the same objectives. Economic
analysis is used to choose the means using the least resources for a given output. All resource
inputs and outputs have an opportunity cost through which the extent and value of project
items are estimated. Projects should be chosen where the resources will be used most
effectively.
20. Economic viability depends upon the sustainability of project effects. Projects are
sustainable if their net benefits or positive effects endure as expected throughout the life of the
project. Sustainability is enhanced if environmental effects are internalized, and if financial
returns provide an adequate incentive for project-related producers and consumers. Sustainable
development is concerned also with distributional issues. When looking at the distribution of
project effects and judging project social acceptability, it is important to determine who

benefits and who pays the costs. An assessment of the capacity of the project to cope with an
uncertain future is another measure. Sensitivity analysis is applied when testing projects for both
productive and allocative efficiency.
21. The scope of economic analysis contained in these guidelines seeks to address several
issues in the economic analysis of Bank project loans (see Figure 1). Previous practice focused
on forecasting demand, choosing least-cost options, and, where possible, calculating the
economic internal rate of return. The demand forecasts themselves depend upon project
charges and affordability, which also affect financial incentives for different participants. At
the same time, environmental effects can now be incorporated into the analysis, and policy
dialogue requires a statement of the distribution of project effects. This broadening of the
scope of economic analysis must be tailored to the particular project and the issues it
generates.
22. In some cases, project preparation does not end with the decision to accept a project.
In process projects, design and appraisal are continual and go along with project
implementation. This allows for greater participation by project beneficiaries in the design and
testing of different options. Economic analysis can be applied at the outset of such projects to
test the underlying rationale. The principles of economic analysis contained in these guidelines
can be applied at key decision points in the process.
23. The procedure for undertaking economic analysis follows a sequence of interrelated steps:
• defining project objectives and economic rationale;
• forecasting effective demand for project outputs;
• choosing the least-cost design for meeting demand or the most cost-effective way of
attaining the project objectives;
• determining whether economic benefits exceed economic costs;
• assessing whether the project’s net benefits will be sustainable throughout the life of the
project;
• testing for risks associated with the project;
• identifying the distributional effects of the project, particularly on the poor; and
• enumerating the nonquantifiable effects of the project that may influence project design
and the investment decision.
For indirectly productive projects, economic analysis would comprise all of the above steps, except
determining whether economic benefits exceed costs.

B. The Project Framework
24. The Project Framework provides a conceptual framework for analyzing both directly
productive projects, for which a direct market demand exists for valuing project outputs, and
indirectly productive projects, for which demand is derived from nonmarket goals. Such an
integrated approach to project appraisal helps to prevent the misallocation of resources. It is
particularly appropriate for projects where benefits are difficult to quantify and value. It provides a
framework for identifying and comparing alternative means of achieving objectives.
25. In the Project Framework, a project is seen as being made up of a series of means-ends
relationships, beginning with input-output linkages, then output-purpose linkages and, finally,
purpose-goal linkages. For each foreseeable year of project implementation and operation, explicit
verifiable targets are set at each level for each objective. The Project Framework is thus both an
appraisal tool and a means by which the project can be monitored for
Figure 1: Scope of Economic Analysis
Directly Productive Projects
(Marketed Outputs)
Indirectly Productive Projects
(Nonmarketed Outputs)
Demand forecasts
Least-cost alternatives
Economic return
Financial incentives
Charges and affordability
Environmental effects
Distribution of net benefits:
gainers and losers
Sensitivity and risk analysis
Policy conditions
Financial plan
Demand forecasts
Least-cost alternatives
Benefit valuation
Charges and affordability
Environmental effects
Distribution of costs
Distribution of benefits
Sensitivity and risk analysis
Policy conditions
Financial plan

• implementation efficiency—testing the input-output linkage;
• operational effectiveness—testing the input-output-purpose linkage; and
• impact significance—input-output-purpose-goal linkage.
26. The Project Framework provides for the identification, quantification, and valuation of
project objectives or targets for inputs, outputs, project effects, and sector impacts. The approach
adopted for economic analysis depends on the extent to which project inputs, outputs, effects, and
impacts can be identified, quantified, and valued. For directly productive projects operating
in a relatively competitive market environment, the economic effects of purpose level
achievements can be measured mainly in terms of incremental income. On the other hand, in
the case of indirectly productive projects, the best that can be expected is to be able to value
project effects indirectly in terms of the project’s impact on the market value of the product
for which the project produces an intermediate input or of the cost of an alternative, in terms
of cost savings.
27. The application of the Project Framework approach to project design provides an
analytical framework for both the economic and social analysis of directly and indirectly
productive projects. By enabling the application of the same criteria, the integrated framework
ensures transparency and accountability, and promotes efficient resource use (see Appendix 3).
C. Financial and Economic Analysis
28. The economic analysis of projects is similar in form to financial analysis: both
appraise the profit of an investment. The concept of financial profit is not the same as
economic profit. The financial analysis of a project estimates the profit accruing to the
project-operating entity or to the project participants, whereas economic analysis measures the
effect of the project on the national economy. For a project to be economically viable, it must
be financially sustainable, as well as economically efficient. If a project is not financially
sustainable, economic benefits will not be realized. Financial analysis and economic analysis
are therefore two sides of the same coin and complementary.
29. Both types of analysis are conducted in monetary terms, the major difference lying in
the definition of costs and benefits. In financial analysis all expenditures incurred under the
project and revenues resulting from it are taken into account. This form of analysis is
necessary to
• assess the degree to which a project will generate revenues sufficient to meet its
financial obligations,
• assess the incentives for producers, and
• ensure demand or output forecasts on which the economic analysis is based are
consistent with financial charges or available budget resources.

30. Economic analysis attempts to assess the overall impact of a project on improving the
economic welfare of the citizens of the country concerned. It assesses a project in the context
of the national economy, rather than for the project participants or the project entity that
implements the project. Economic analysis differs from the financial analysis in terms of both (i)
the breadth of the identification and evaluation of inputs and outputs, and (ii) the measure of
benefits and costs. Economic analysis include all members of society, and measures the
project’s positive and negative impacts in terms of willingness to pay for units of increased
consumption, and to accept compensation for foregone units of consumption. Willingness to
pay and willingness to accept compensation are used rather than prices actually paid or
received because
• many of the project impacts that are to be included in the economic analysis either
will be nonmarketed, for example, biodiversity preservation, or incompletely
marketed, such as, water supply and sanitation benefits. Thus, some form of
nonmarket value must be estimated.
• many project impacts that are marketed will be bought and sold in markets where
prices are distorted by various government interventions, by macroeconomic policies,
or by imperfect competition.
Shadow prices may be used in estimating the willingness to pay and willingness to accept
compensation values in the face of these market absences and market imperfections.
31. The benefits from a project constitute the extent to which the project contributes to
increasing the value of the consumption available to society. Consumption can be defined
broadly. Societal consumption may apply equally well to a society’s willingness to pay for
preservation of plant or animal species, as to society’s willingness to pay for the consumption
of agricultural produce or clean drinking water.
32. Costs reflect the degree to which consumption elsewhere in society is sacrificed by
diverting the resources required by the project from other uses. The total net changes in
consumption available to the society represent the net impact of the project. When the units
of consumption are valued in terms of marginal willingness to pay for the units of increased
consumption and marginal willingness to accept compensation for foregone units of
consumption, the resulting economic net benefits from the project will reflect the summation
of the changes in the net income of the society as a whole, resulting from the situation with
the project compared with that without the project.
33. Shadow prices are used to take into account the major impacts of a project where
economic values differ from financial values. In many developing member countries, many
prices paid and received in the project accounts may come from relatively complete markets
where the major impacts are captured in the transaction between buyer and seller, and are
reflected by the prices paid and received. As structural adjustment and sectoral adjustment
measures proceed, and as projects involving institutional and organizational approaches to

market development are successfully implemented, the differences between financial values
and economic values may lessen. The overall objective of the structural and sectoral
adjustment programs, and of the projects financed by the Bank, is to attempt to create just
such an economic environment in the Bank’s developing member countries.
VI. IDENTIFICATION AND QUANTIFICATION OF COSTS AND BENEFITS
A. General
34. There are four basic steps to analyzing the economic viability of a project:
• identify the economic costs and benefits;
• quantify the costs and benefits, as much as possible;
• value the costs and benefits; and
• compare the benefits with the costs.
The first two steps can generally be undertaken together. However, there will be some types of
benefits, and sometimes costs, that cannot be quantified and valued for inclusion in the cost-
benefit comparison. They will simply be stated alongside the results of the economic analysis.
35. To identify project costs and benefits, the situation without the project should be
compared with the situation with the project The without-project situation is not the same as
the before-project situation. The without-project situation can sometimes be represented by
the present levels of productivity of the relevant resources. However, present levels of
productivity would frequently change without the project, and this should be taken into
account in defining the without-project situation.
36. The comparison of without-project and with-project situations is at the heart of the
estimation of net benefits for any project. While, in practice, appraisal reports provide a clear
specification of the with-project situation, they frequently provide little analysis of the
without-project situation. The without-project situation is often inaccurately described. The
without-project situation is that which would prevail without the project. It is not the
implementation of the next best project alternative, unless there is clear evidence to suggest
that this is most likely to be the case. Similarly, the without-project situation is not the delayed
implementation of the same project. In most cases, it is a modification of the existing
circumstances. In comparing project alternatives, the without-project situation follows the
same scenario, and provides the basis for comparing with-project net benefit flows for each
project alternative.
37. Most projects or subprojects are regarded as marginal in the sense that they will not
have any effect upon the prices of project inputs and outputs, and will not have a substantial
impact on the government budget or the exchange rate. Additional factors will have to be

taken into account in the case of large projects that have a considerable impact on the
regional, national, or international economy.
38. An important distinction in identifying project benefits and costs is that between
nonincremental and incremental output, and between incremental and nonincremental
inputs. The distinction is important because nonincremental and incremental effects are
valued in different ways. It should therefore be used in the identification and quantification of
project effects. Nonincremental outputs are project outputs that substitute for existing
production. For example, a new hydropower plant may in part substitute for existing coal-
fired generation. Incremental outputs are project outputs that expand supply to meet new
demands, for example, the growing demand for electricity as generation and transmission costs
decline. Incremental inputs are project demands that are met by an increase in total supply of
the input, for example, where an increase in demand for water is met by an overall expansion
of the water supply system. Nonincremental inputs are project demands that are met not by
an expansion of overall supply but from existing supplies, that is, by competing supplies away
from existing producers. Each project will exhibit different degrees of nonincremental and
incremental effects for both outputs and inputs. Part of the process of forecasting involves
analyzing these effects for the main project outputs and inputs.
B. Identification and Quantification of Benefits
39. For directly productive projects, the main benefits will be in the form of production
that is sold. It is important to determine whether a project’s output is incremental to existing
supplies. If the project is small relative to the size of the market, it is likely that the project
output will be fully incremental. This is the case for most outputs that are traded
internationally. In the case of an output that is nontradable, project supply can cause price
effects where nonincremental output displaces sales from higher-cost producers.
40. The need for services from indirectly productive projects will depend on underlying
factors, such as the rate of economic growth for freight transport or the rate of population
growth for water and health services. A key feature of a sector or project analysis will be the
phasing of investments to match the demand for services. For most indirectly productive
projects, the type and extent of expected benefits can be quantified through such factors as
time and cost savings, increased access, improved health, and so on, most of which have a
productive effect, as well as a direct effect on welfare.
41. Some benefits of indirectly productive projects will not be quantifiable. For example,
a newly sited bridge may not only reduce travel time for haulage trucks, but may also
encourage greater social and political interaction by those on both sides of the river. A dam
project may create a reservoir that not only can be used for fishing or recreational purposes,
but also can have a scenic value for existing inhabitants. Such benefits should be stated along
with an estimate of the number of beneficiaries.

42. Project benefits also include the extent of any consumer surplus. A project may lower
the price of the output for all consumers. The savings to existing consumers, because of the
difference between what they are willing to pay and what they will now have to pay, is not
reflected in the financial effects. Consumer surplus can also arise when the output price is
fixed by government below the demand price. The difference between the actual price and
what consumers are willing to pay can be estimated through a price elasticity of demand, if
available. If no direct estimate of the elasticity is available or can be estimated, then the likely
magnitude of this form of benefit should be discussed (see Appendix 4).
C. Identification and Quantification of Costs
43. While several types of cost need to be included in the economic analysis of a project,
some types of financial cost must be excluded. The underlying principle is that project costs
comprise the difference in costs between the without and with project situation, that is, the
extra use of resources necessary to achieve the corresponding benefits.
System Costs
44. If a project is part of a larger system, then the expected benefits may not accrue unless
some matching investments are made. For example, power generation benefits rely on
investments in transmission and distribution. A highway section may need investment in
preceding sections or interchanges for the expected traffic flow and cost savings to occur. The
project boundary must include the total system investment required to achieve the benefits
and, correspondingly, the total system benefits. If the total system of investments is viable,
then the project can also be considered viable.
Sunk Costs
45. A project may require the use of facilities already in existence. The costs of such
facilities are sunk costs and should not be included in the project cost, provided their use in
the project involves no opportunity cost. Put another way, sunk costs are those costs that
would exist both without and with tie project, and thus are not additional costs for achieving
project benefits.
46. Many projects will be implemented through existing enterprises or agencies. The
project analysis must separate the additional agency costs from the whole cost structure of the
enterprise. At the same time, the project may succeed only if the enterprise itself is stable. The
analysis of the whole enterprise, including sunk costs together with the project, is necessary to
determine financial sustainability (see Guidelines for Preparation and Presentation of Financial
Analysis, 1989).

Contingencies
47. Contingency allowances, which are determined by engineering and financial
considerations, also have implications for economic appraisal. When estimating project costs
for financial planning purposes, both physical and price contingencies are included. Since
economic returns are measured in constant prices, general price contingencies should be
excluded from the economic cost of the project. Physical contingencies represent the monetary
value of additional real resources that may be required beyond the base cost to complete the
project, and should be treated as part of the economic cost of a project
Working Capital
48. Working capital is commonly defined in financial analysis as net current assets,
consisting of inventories, including goods in process; net receivables; marketable securities;
bank balances; and cash in hand. A certain amount of working capital is normally required to
run project facilities created by investment in fixed assets. For purposes of economic analysis,
only inventories that constitute real claims on the nation’s resources should be included in the
project economic costs. Other items of working capital reflect loan receipts and repayment
flows, and are not included in the economic cost (see Appendix 5).
Transfer Payments
49. Some of the items included in the financial costs of a project are not economic costs,
as they do not increase or decrease the availability of real resources to the rest of the economy.
These items will, however, affect the distribution of financial costs and benefits between the
project entity and other entities, and among project beneficiaries. They are thus referred to as
transfer payments, as they transfer command over resources from one party to another
without reducing or increasing the amount of resources available as a whole. Taxes, duties, and
subsidies are examples of items that, in some circumstances, may be considered to be transfer
payments. They can affect the income of the government, and that of the payer and the
recipient simultaneously and in opposite and identical amounts, thus canceling out in an
economic analysis summation. However, there are circumstances when tax and subsidy
elements should be included in the price of an input or output. The economic cost of an input
should include the tax (subsidy) element, if the demand is nonincremental. If the government
is correcting for an externality by applying a tax or a subsidy to reduce or to increase
production, for example, where a tax is levied on project output that is equivalent to the costs
of waste processing undertaken by a government agency, the economic cost of the input
should also include the tax element. Finally, the economic value of incremental outputs will
include any tax element imposed on the output which is included in the market price at which
it sells.

Depreciation
50. The financial accounts of agencies implementing a project will include provision for
depreciation and amortization on the basis of prevailing accounting practice. However, for
project economic analysis, the stream of real investment required to realize and maintain
project benefits is included in the resource flow, together with a residual value for these assets
at the time they are released from project use at the end of the project’s life. The stream of
investment assets includes initial investment and replacements during the project’s life. This
stream of expenditures generally will not coincide exactly with the time profile of depreciation
and amortization in the financial accounts.
Depletion Premium
51. Many projects involve the exploitation of a nonrenewable natural resource, such as
oil, natural gas, or mineral deposits. The economic cost of using these natural resources must
be included in the economic analysis. Because they cannot be replenished, and when depleted
must be replaced by imports or domestic substitutes, the opportunity cost of the resource
includes the cost of the substitutes when the resource is exhausted. The depletion premium or
allowance depends on this economic price and the proportion of the total reserves exploited
during each year. It is added to the economic cost of exploitation to arrive at the full
economic cost of using the nonrenewable resource. If the resource will not be exploited to
exhaustion, the salvage value of the land at the end of the project must include the economic
value of any remaining undepleted reserves (see Appendix 6).
External Costs
52. In many projects, effects will go beyond the financial analysis from the point of view
of the implementing agency. These external effects may include significant costs that must be
accounted for in an economic analysis from the national perspective. For example, increased
air and water pollution from an industrial plant may be measured and its effects on
surrounding entities estimated. In some cases, it may be helpful to internalize these external
costs by including all relevant effects and investments in the project statement, including, in
this case, pollution control equipment costs and effects.
VII. VALUATION OF ECONOMIC COSTS AND BENEFITS
A. General Considerations
53. Once the costs and benefits of a project have been identified and quantified, they
should be valued according to a common criteria. This allows them to be aggregated and
compared. Decisions by producers and users of project output will be based on financial
prices. However, to evaluate the consequences of their decisions for the national economy,

costs and benefits need to be valued at economic prices that represent their value from the
national economic perspective.
54. Costs and benefits should be valued in constant prices, that is, in terms of the price
level prevailing in the year in which the project is appraised. Any expected change in the
general price level can be ignored. However, if it is expected that there will be significant
changes in relative prices over the life of the project, for example that the output of a food
production project will decline in value relative to prices in general, then this relative price
change must be incorporated in the valuation of the cost or benefit item (see Appendixes 7
and 8).
55. In an economic analysis, market prices are adjusted to account for the effects of
government intervention and market structure. The result is shadow prices. For project
outputs, the shadow price is based on the supply price, the demand price, or a weighted average
of the two. Where project output is nonincremental, that is, where it substitutes for alternative
forms of supply, then the shadow price is based on the supply price of these alternative forms
of supply—on the market price, less any production taxes, plus any subsidies on the alternative
supplies. This supply price in turn must be adjusted for the effects of government intervention
and market structure on the inputs going into the alternative production. Where project
output is incremental, that is, where the project provides additional output compared to the
without project case, then the shadow price is based on the demand price for that output—on
the market price inclusive of any consumption tax and exclusive of any subsidy falling on the
buyer. This demand price also must be adjusted for the average difference between economic
and market prices, as explained further below. In many cases, a project will produce a
combination of nonincremental and incremental output. In such instances, the shadow price
of the output is based on a weighted average of the supply and demand prices (see Appendix
9).
56. For small projects producing an import substitute good, the whole output will be
nonincremental. It can be valued through its supply price, that is, through its import price.
For small projects producing an export good, the whole output will be incremental. It can be
valued through its demand, or export, price. For a project producing a combination of import
substitute and export prices. This valuation process becomes more complicated when the project that
produces traded goods is large and will have an impact on international prices. The
impact must be considered when applying supply and demand prices.
57. The same principles of valuation apply to projects producing outputs that are
nontraded. Generally, some of the nontraded output will be nonincremental. The shadow
price is based on the supply price of the alternative supply being displaced. Also, some of the
nontraded output will be incremental. The shadow price is based on the demand price or
willingness to pay of the new users. The shadow price of total nontraded output will be based
on a weighted average of the supply and demand prices.

58. In practice, it may be difficult to identify and separate the nonincremental from the
incremental output of a project. This is particularly so for projects producing nontraded
outputs that are quite large and may have an impact on demand and supply prices. The
proportion of nonincremental to incremental output will depend on the elasticities of demand
and supply. The data available, and interview structure needed to estimate the willingness to
pay of new users, may not provide sufficient information to provide reliable estimates of
relevant elasticities and, therefore, output proportions. In such circumstances, an estimate of
the supply price for alternative supplies, that is, the cost of supply without the project, may be
applied to the whole of the nontraded output, both nonincremental and incremental.
59. The shadow price of project inputs is also valued through a weighted average of their
supply and demand prices. However, in the case of inputs, the valuation of nonincremental
and incremental inputs is the reverse of the case for outputs. For nonincremental inputs, that
is, for input supplies that are competed away from other uses, the shadow price is based on the
adjusted demand price or willingness to pay for the input. For incremental inputs, that is, for
nontraded inputs where production is expanded, or for traded inputs where additional supplies
are imported or substitute for exports, the shadow price is based on the adjusted supply price
of the input, that is, on the supply price of additional domestic production for a nontraded
input, and on the import or export price for traded inputs. In the case of a nontraded input in
fixed supply, or in the exceptional case of a very large increase in demand for a traded input
that affects its price, the shadow price is based on with-project supply prices that may require
relevant elasticity estimates to predict.
60. The basis for valuing incremental and nonincremental outputs and inputs is
summarized in Table 1. The relevant supply or demand prices have to be adjusted for the
effect of trade controls and market structures that create a difference between financial and
economic values. Therefore, the shadow price of an output or input is the weighted average of
its supply and demand prices adjusted for these additional factors.
Table 1: Basis of Economic Valuation of Project Outputs and Inputs
Incremental Nonincremental
Outputs Adjusted demand price Adjusted supply price
or willingness to pay or opportunity cost
Inputs Adjusted supply price Adjusted demand price
or opportunity cost or willingness to pay
B. Role of World Prices
61. One approach to estimating the value of outputs and inputs from the national point
of view uses world market prices. The extra outputs and demand for inputs created by a
project will have a direct or indirect effect on international trade. World market prices are also
subject to national and international policy effects and, in some cases, to monopolized market
structures. However, trade represents an alternative to domestic production for most goods

and services. Hence, world prices can be used to measure the value of project inputs and
outputs from the national perspective.
62. The valuation of outputs and inputs through world prices requires that the trade
effect of each project item be identified. Incremental outputs that are exported can be valued
at the export demand price and outputs that substitute for imports can be valued at the import
supply price. Where a project’s output involves both substituting for imports and an
expansion of exports, it should be valued at the weighted average of import supply and export
demand price. Incremental inputs that are imported can be valued at the import supply price,
while inputs that reduce the level of exports can be valued at the export demand price. Where
extra inputs involve both a reduction in exports and an increase in imports, they should be
valued at the weighted average of the export demand and import supply price. World prices
will differ from the domestic prices used in the financial analysis of the project because of
• the effects of trade controls and net taxes on traded goods;
• the monopoly pricing of some traded goods; and
• subsidy levels, especially for utility prices.
Adjusting prices to world prices in effect excludes all tax and subsidy elements from project
input costs and ensures that outputs are valued at their worth to the national economy. Any
excess operating surplus, over and above production or supply costs including a capital charge,
resulting from monopoly supplies of nontradable outputs or inputs, should also be excluded.
63. Applying world prices to measure the marginal value of project outputs and inputs
can be directly applied to traded project items. They can also be applied indirectly to the
incremental production costs of project inputs that are nontraded. However, they cannot be
applied directly or indirectly to outputs that have no trade effect (see Table 2).
Table 2: Valuation of Main Project Outputs and Inputs
Category Project Impact Basis of Basis of
Economic Price Valuation
Output Tradable Incremental Demand price WMP (= FOB)
Nonincremental Supply price WMP (= CIF)
Nontradable Incremental Demand price DMP + CT
Nonincremental Supply price DMP - PT - OS
Input Tradable Incremental Supply price WMP (= CIF)
Nonincremental Demand price WMP (= FOB)
Nontradable Incremental Supply price DMP - PT - OS
Nonincremental Demand price DMP + CT
CIF - Cost insurance freight OS - Operating surplus
CT - Net consumption tax PT - Net production tax
DMP - Domestic market price WMP - World market price
FOB - Free on board

64. All project items should be valued using the same reference point. There are different
levels of prices: producer prices, wholesale prices, and retail prices. The economic prices of all
outputs and inputs should be valued at the project level. Generally, this means at the point of
production for the project or subproject. World prices and other forms of valuation should be
adjusted to the level of the project for purposes of comparing the economic value of project
costs and benefits.
C. Economic Prices of Traded Goods and Services
65. Project effects estimated in terms of traded goods and services can be measured
directly through their border price equivalent value—the world price for the traded product for
the country concerned, adjusted to the project location. The steps involved are summarized at
the end of Appendix 10. The world price for the country is the border price, the price in
foreign exchange paid for imports inclusive of insurance and freight at the port or, for
landlocked countries, at the railhead or trucking point; or the world price received for exports
at the port, railhead, or trucking point. Border prices for exported outputs can be adjusted to
the project location by subtracting the cost of transport, distribution, handling, and processing
for export measured at economic prices. Border prices for imported inputs have to be adjusted
by adding such costs to the project site. Outputs that substitute for imports should be adjusted
by the difference in transport, distribution, and handling costs between the existing point of
sale and the project site. Project inputs that reduce exports should be adjusted by the difference
in costs between the point of production and the project location. In each case, the traded
good or service is estimated through its border price equivalent value (BPEV), adjusting for the
economic cost of local costs (see Table 3 and Appendix 10).
Table 3: Border Price Equivalent Value Adjustments
Outputs
Exported FOB price less PTDH from project
Import substitutes CIF price plus TDH to market
less TDH market to project
Inputs
Imported CIF price plus TDH to project
Export substitutes FOB price less PTDH production to port
Plus PTDH production to project
CIF - Cost insurance freight
FOB - Free on board
PTDH - Processing, transport, distribution, handling in economic prices
TDH - Transport, distribution, handling in economic prices
66. World prices are not stable. They fluctuate from year to year. The world price from
which border price equivalent values are derived should be expressed as an annual average
price over successive fluctuations. Also, it should be adjusted for any quality differences
between the world price reference product and project outputs and inputs. World prices are
also subject to long-term relative price changes. Where it is forecast that the real price of a

traded product, the forecast nominal price deflated by an index of world prices, such as the
unit manufacturing value added index, will increase or decline over time, then the forecast real
price for future years should be used in the project economic statement. This applies to major
outputs and major inputs that are traded internationally. Bank analysis uses the forecast real
prices of commodities published quarterly by the World Bank.
67. In most cases, world prices will not be affected by a single new project. However,
where a country produces a high proportion of world output, for example production of
timber, the effects of extra output on the world price itself should be taken into account. The
marginal export revenue allowing for the effects on price of greater supply should be
estimated. Similarly, where a project creates additional demand for an input that is large
relative to world supplies, such as for lucretia extract, the input should be valued at its
marginal border price equivalent value allowing for the effect on world prices of the additional
demand. In these cases, elasticity estimates are required at present world price levels to estimate
the marginal export or import effect (see Appendix 10).
68. Differences between domestic market prices and border prices of traded goods occur
because of net tax and trade controls, the project location, and the monopolization of
domestic markets. Valuing traded goods at their border price equivalent values and adjusting
for the effects of net taxes and controls, the economic costs of local costs, and monopoly
rents, removes the differences between domestic and world market prices. Initially, border
price equivalent values will be estimated by converting all foreign exchange values into
domestic currency at the official exchange rate. However, the exchange rate, through which
traded goods and nontraded goods valued at domestic market prices are made comparable,
may itself be a cause of difference between domestic and border price equivalent values. The
use of a shadow exchange rate or its converse, the standard conversion factor, is discussed later.
D. Economic Prices of Nontraded Goods and Services
69. The Bank is increasing its lending in areas where the project outputs are nontraded.
The steps involved in estimating the economic value of nontraded output and inputs are
summarized at the end of Appendix 11. While public utility, social sector, and environmental
projects produce effects that are nontraded, many directly productive projects also have
nontraded effects. Some will be marketed, such as port services or urban water and sanitation
supplies.
70. Goods and services may be nontraded for different reasons. By their nature, some
goods and services, such as domestic transport and construction, are products that must be
produced and sold within the domestic economy. Sometimes goods and services are nontraded
because of government policy decisions that they should not be exported or imported. Finally,
some goods and services may be nontraded because their cost and quality are such that,
although they can be sold in the domestic market, there is no international market. In some
cases, nontraded inputs and outputs have close substitutes that are traded. For example,

domestic firewood can be converted into the calorific equivalent of kerosene or gas. In these
cases, the equivalent in traded products can be used to provide an economic price for the
nontraded products. However, in most cases of nontraded products there will be no close
substitute that is traded.
71. Nontraded goods and services used as project inputs, where additional project
demands result in increased supply, can be valued in terms of their supply price, the marginal
economic costs of extra supply. The marginal cost will differ between situations where spare
capacity already exists and only variable operating costs will increase, and situations where
there is no existing spare capacity, and the marginal cost will include a capital element as well.
In either case, the traded component of the marginal cost structure can be valued at border
prices, and the economic value of any remaining nontraded element in the marginal cost
structure can be approximated by use of a group or standard conversion factor (see Section H
below). Use of the marginal cost of supply converted to its economic value will fully account
for the differences between domestic market and world prices.
72. It is not relevant to estimate a marginal cost of production for nontraded inputs in
fixed supply. The demand price must be applied. Here the valuation of the input must rely on
the willingness to pay principle: an estimate should be made of the price that different users
are willing to pay for receiving or retaining input supplies. This will provide a value for the
nontraded input in fixed supply.
73. Extra demand by a project for nontraded inputs, such as transport, construction,
water, and power, may have both an incremental effect, where additional supplies are
provided, and a nonincremental effect, where supplies are competed away from existing users.
The economic price of the nontraded input will be the weighted average of the marginal
supply cost and the demand price.
74. Most nontraded outputs will be incremental; they will provide additional supplies of a
nontraded good. Incremental nontraded outputs should be valued at their demand price, that
is at the average of their value to the new consumers with and without the project. The value
to consumers is inclusive of any indirect tax on the output and net of any subsidy.
Nonincremental nontraded output should be valued at its supply price, that is, taking into
account the cost of supply of the alternative output being displaced.
75. Because nontraded outputs and nontraded inputs are, by definition, produced and used
in the domestic economy, the effects on the domestic markets of extra output and extra
demand may be significant. In each case, the effect on the price of the nontraded good and the
responsiveness of demand to price changes need to be considered.
76. Where an increase in transport services, or a road improvement scheme, brings about
a reduction in transport charges, in addition to the value of the output with the project, there
will be a benefit to existing users of transport services given by the without-project demand

times the price reduction. Most of this benefit will be offset by a decline in producer surplus.
The net effect is equal to the nonincremental output valued through the average supply price.
There will also be additional benefits to new users. The value is generally approximated by the
average of the price with and without the project, times the change in demand. However, to
estimate both effects, an estimate is required of the effects of the project on total supplies, and
on the price of the nontraded good. Reaching an estimate of the without- and with-project
quantities and the price is the key step in evaluating project effects. The corresponding
financial prices need to be converted to their equivalent economic values for economic
analysis.
77. In many instances, the supply of nontraded output will be monopolized in public or
private hands. An increase in supply may not be associated with a decrease in price. In this
case, benefits will accrue to new, but not to existing, users. Similar modifications can be made
for valuing nontraded inputs and outputs in differing circumstances (see Appendix 11).
78. Many Bank projects produce nontraded outputs that are also nonmarketed; these are
generally public goods. Public goods can be defined in terms of excludability and
subtractability, as in paragraph 11 above. Public goods, such as uncongested roads, have low
subtractability and low excludability. The marginal cost of using them is generally close to
zero. However, public goods usually provide considerable economic benefits.
79. Nonmarketed outputs can be valued through direct willingness to pay measures, such
as contingent valuation, travel cost, or other surrogate market techniques. More frequently,
public goods are valued in terms of the changes they cause in the value of closely related
private goods, or in the productivity of private sector activities. The public good is treated as
an intermediate good in the production of a final private good. The value of the
“intermediate” public good is then derived from the value of the private good it ultimately
produces. This is particularly relevant when valuing infrastructure services, such as roads and
bridges, and social services, such as education and health, which can have a measurable effect
on private sector productivity.
E. The Economic Price of Labor
80. Labor is an important component of any project. The demands for labor for the
project should be broken into two basic categories: types of labor that are scarce and types that
are in surplus supply. Scarce labor consists of those workers who would be able to find
alternative employment in a short time, that is, where supply is more or less in fixed supply in
the short term. This generally includes vocational and technical occupations; it also generally
includes managerial and professional occupations, although in some countries there is a
surplus of labor with educational rather than vocational qualifications.
81. For most labor that is scarce, the cost of labor inclusive of benefits can be taken as its
demand price. This provides an estimate of its opportunity or economic cost—the output

foregone elsewhere in the economy when labor moves to the new project. In some cases, where
as a matter of policy wages have been held down in the public sector, or in transitional
economies where substantial pay differentials have been discouraged, the value of production
foregone may be greater than the demand price of scarce labor, and an upward adjustment to
the cost of labor may be made. For foreign labor drawn into an economy, the economic cost
to the economy will include the cost of its local consumption at economic prices, plus any
remittances from the country of employment, plus the cost of any additional benefits or
facilities such as health or education provision that has to be made.
82. Surplus labor consists of categories for which there would, in general, be a long search
time between jobs. For these types of labor, the project wage is usually at or above the supply
price. Analysis of the impact of additional project employment generally involves interlinked
labor markets. The ultimate effect may be far from the project itself, and this effect will differ
from project to project. The cost to the economy of surplus labor in a new project is its supply
price, which approximates the opportunity cost of net output lost elsewhere; plus additional
economic costs of social infrastructure provision not borne by the project itself.
83. Often the effect of a project may be to draw surplus labor from rural areas or from
agricultural production. An estimate can be made of the lost production that would result
from labor migration. This estimate can be expressed in terms of a traded good that has a
border price equivalent value. Some lost production will include nontraded agricultural output
where, in the case of well-developed local markets, the demand price can be used as an estimate
of the opportunity cost.
84. Identifying the lost rural production associated with one additional project job can be
time consuming. It may include nonagricultural, as well as agricultural, products. It may
include an imputed value for lost production that is produced by family labor but not
marketed. An indirect alternative is to use rural wage estimates as a proxy for opportunity
costs. Rural casual wage rates in competitive markets represent the value placed on surplus
labor in the region from which it is drawn, and hence its supply price. Casual wage rates can
be reexpressed in annual terms and used as a measure of opportunity cost.
85. With increasing city size and growing numbers of urban poor, many projects draw
labor from urban rather than rural areas. Surplus labor in the urban context supports itself
through many informal activities. The outputs of these informal activities are generally
nontraded products sold only in the domestic market. Estimates of annual incomes in the
urban informal sector can be used as a measure of opportunity cost for labor drawn into
projects from urban areas. The estimate of income can be associated with a range of urban
goods and services for purposes of estimating an economic value.
86. Some projects, especially in the industry sector, use predominantly young female
labor. Such labor may play a different role in the rural or urban economy from which it is
drawn, depending on local customs and family structure. Generally, there are further costs

associated with female rather than male labor. These relate to the provision of goods and
services in the household. The migration of female labor to new jobs, especially where it
involves geographic migration as well, may lead to a decline not just in marketable production,
but also in household production that is not marketed. Estimates of this additional element of
opportunity cost can be made through the purchase cost of equivalent services and should be
included in the economic cost of labor for projects using predominantly female labor.
87. The economic price of different categories of labor can be expressed in relation to the
full wage of the same category of labor to form the shadow wage rate factor (SWRF). The
SWRF for surplus rural labor is the ratio of the opportunity cost of rural labor plus the
economic costs of migration to the project wage for surplus labor. Similarly, the SWRF for
scarce labor is the ratio of its economic and financial price. In each case, the supply price of
surplus labor and the demand price of scarce labor have to be adjusted for the general level of
distortions in the economy (see Paragraph 104 and Appendix 12).
F. The Economic Price of Land
88. All projects involve some use of land. Even where land has no financial cost, its
economic value should be estimated and included in the calculation of economic viability. The
demand price for land does not always give an accurate reflection of the economic value of
land because supply cannot be expanded and land can be held for speculative, as well as
productive, purposes or to meet immediate needs. The value of land is best determined
through its opportunity cost—what it would have been used to produce without the project. In
a relatively competitive land rental market, land rent is generally a good estimate of the
opportunity cost. Where relevant, the economic costs of resettlement should be included in
the cost of land, if such costs are not included already in the project costs.
89. For rehabilitation and improvement projects, the same area of land may be included
as in the original project. Here the economic price of land will be included in the without-
project net output estimates. However, for new and expansion projects, the economic price of
land needs to also include the opportunity cost of land undergoing a change of use. The
alternative net output from the land undergoing a change of use, at economic prices, will
differ from project to project.
90. For new projects in rural areas, the opportunity cost of the land will be the net
agricultural output foregone, measured at economic prices. This opportunity cost should be
estimated on an annual basis. Over the life of the project there may be an increasing or
decreasing trend in agricultural productivity, which should be incorporated into the
opportunity cost estimate. A similar approach can be used for city-edge land, where
agricultural uses are displaced by infrastructure, industrial, or housing projects. In this context,
owing to greater access to urban markets and facilities, the future opportunity cost is likely to
considerably exceed the present productivity of the land.

91. The same principle can be applied, but with greater complexity, in the city center
context; for example, when road construction displaces housing, offices, commercial and
industrial activities, and recreational uses. The extent of land use change for each type of
activity can be calculated and valued accordingly, considering the lost production at economic
prices for directly productive industrial and commercial activities; the cost savings through
relocation of indirectly productive activities; and the willingness to pay for recreational and
other public amenities. The economic cost of land also includes the opportunity cost of land
used for the resiting of the displaced activities, which may be at other city-edge locations.
92. Many countries are implementing a series of special export or development zones.
Here the opportunity cost of the land may change dramatically over a short period of time.
Previously, relatively unused, poor agricultural land could be transformed through
infrastructure investment into highly valued land for industrial, financial, or commercial
purposes. Where land markets develop or where rents are set on a competitive basis, the
market price of the land can be used to estimate its productive value in this context. In
addition to the opportunity cost of land use, the costs of land development should also be
included as an economic cost of the project (see Appendix 13).
93. Many natural resources, such as land, are depletable. When a natural resource is
depletable, its economic cost will comprise both its opportunity cost in terms of benefits
foregone from its best alternative use and its scarcity rent. While the consequences of land
degradation represent an increasing threat to agricultural production, other natural resources,
such as groundwater, are closer to exhaustion. In the case of groundwater, the finite capacity
of aquifers means that when withdrawal rates exceed the rate of recharge, an alternative water
source must eventually be found. The higher future cost of obtaining water implies a scarcity
rent or depletion premium (see Appendix 6). Even in the case of surface water, scarcity rent is
relevant when pricing raw water. When a water utility approaches its legal entitlement from a
river source, it has to find an additional source if it is to meet growing demand. Typically,
only higher cost sources are left, and this in itself implies a scarcity rent. If, on the other hand,
a water utility is able to purchase new water rights on the open market, the scarcity rent
becomes an explicit part of the price paid for raw water, and the market price of raw water is
equal to its economic price. Similar considerations apply in valuing other depletable national
resources, such as mineral deposits or national fish stocks.
94. Many Bank-funded projects involve resettlement of people and economic activities.
Sometimes resettlement may be a major component of project planning and costs; other times
it may affect only a small number of people and activities. Generally resettlement cannot
expect to recreate exactly the living conditions or income opportunities that are displaced.
Resettlement itself should be seen as a development subproject, requiring its own institutional
structure and financial resources. There will be economic costs, both direct and in terms of
lost output, as well as potential benefits that can be identified by analyzing the situation with
and without resettlement (see Appendix 14).

G. Bringing Economic Prices to a Common Base
95. If the above principles are followed in estimating economic benefits and costs, then
most project effects will be valued at their border price equivalent value. This will apply for
traded goods and services, for the opportunity cost of surplus labor, for the opportunity cost
of land, and indirectly for nontraded inputs with increasing supply. However, other items,
such as the opportunity cost of scarce labor, nontraded products in fixed supply, and especially
nontraded outputs, will be valued initially in domestic market price values. These two forms of
valuation need to be brought to a common base so that they can be aggregated and compared.
96. The aggregation of costs and benefits requires a unit of account to be established in
terms of the currency and the price level in which the analysis is to be conducted. Economic
analysis can be undertaken in the currency of the borrowing country or a foreign currency,
and at the domestic or the world price level. Bank economic analysis generally will be
undertaken in the currency of the borrowing country. For reasons given below, there is also a
preference for using the domestic price level to conduct economic analysis. However, there
may be circumstances when the world price level is preferred.
97. Domestic market price values differ from border price equivalent values. Generally,
domestic prices are higher than world prices. This means that purchasers in the domestic
market, in general, place a higher value on imported and exported goods and services than is
indicated by the border price equivalent value of those items. The difference between the
domestic market price and the world market price equivalent represents the extent to which
purchasers are willing to pay above the direct foreign exchange cost or value of the goods and
services. The economic price of foreign currency—the shadow exchange rate—rather than the
actual price of foreign currency—the official exchange rate—should be used in the economic
valuation of goods and services. The shadow exchange rate is the weighted average of imports
and exports in domestic prices to the border price equivalent value of the same goods.
98. The shadow exchange rate is greater than the official exchange rate to the extent that
domestic market prices for goods and services exceed their border price equivalent value. Even
where the official exchange rate is market-determined, it will differ from the shadow exchange
rate. The former is affected by income and capital flows; the latter refers only to goods and
services. Where foreign exchange markets themselves have been liberalized, there will remain a
difference between the domestic market price and world market price values for traded
products, because of trade controls and taxes, and monopolized markets.
99. The shadow exchange rate is estimated by comparing the demand for, and supply of,
foreign exchange for trade purposes. Where demand and supply are elastic with respect to
price, the shadow exchange rate can be estimated by directly comparing the domestic market
price value of all traded products with their world market price value. The shadow exchange rate
factor (SERF) is calculated as the ratio of the shadow exchange rate to the official
exchange rate. This factor will generally be greater than 1. The SERF is applied to all outputs

and inputs, including labor and land, that have been valued at border price equivalent values.
Project effects measured at domestic market price values are left unadjusted. In this way, all
project effects are brought to a common basis of measurement in the currency of the
borrowing country at the domestic price level.
100. This method of adjusting border price equivalent values to the equivalent domestic
price level is called using the domestic price numeraire. Project effects, as far as possible, are
still measured at border price equivalent values. These values are reexpressed to correspond to
the level at which the remaining project items are measured. This use of the domestic price to
express all economic costs and benefits has the distinct advantage of corresponding to the
price level at which the constant price financial analysis is undertaken. The distribution of net
economic benefits among project participants can therefore be traced more easily in assessing
financial and fiscal sustainability, as well as affordability and acceptability (see Section XII).
101. An alternative approach can be used to adjust all project items to a common basis of
comparison. Domestic market price values are in general higher than border price equivalent
values. Instead of adjusting border price equivalent values upward, using the SERF, the
domestic market price values of project items, measured through willingness to pay or other
nontraded measures, can be adjusted downward. This can be done using the standard
conversion factor (SCF), which is simply the inverse of the SERF. It represents the extent to
which border price equivalent values, in general, are lower than domestic market price values.
It is applied to all project items valued at their domestic market price to convert them to a
border price equivalent value. If this is done, they can be aggregated together and compared
with all other project items valued at their border price equivalent values, in the currency of
the borrowing country at the world price level.
102. Use of the standard conversion factor in this way is called using the world price
numeraire. Most project effects are still measured at border price equivalent values. All project
effects are brought to this level of valuation. The use of the world price numeraire may be
preferred in small open economies, where it is simple to think in foreign exchange terms. It
may also be preferred in transitional economies, where there remain numerous administered
prices or subsidized enterprises and products. In the latter case, the unit of account may also
be changed. Instead of expressing all effects in domestic currency, project effects may be
expressed in foreign exchange units directly, but still using the standard conversion factor as
well as the official rate of exchange to convert nontraded values to border price equivalent
values. However, use of the world price numeraire in domestic or foreign currency units when
assessing economic viability means that to make further comparisons with the distribution of
net financial benefits in sustainability analysis, project effects would all have to be converted
back to domestic market price values.
103. Estimation of the shadow exchange rate factor or the standard conversion factor can
be done from time to time on a country basis. Which is applied, that is, which numeraire is
chosen for the analysis affects the absolute value of economic costs and benefits, but not the

economic internal rate of return (EIRR) of the project. All values using the domestic price
numeraire—both costs and benefits—will be greater than the corresponding values using the
world price numeraire by a fixed amount given by the SERF. Conversely, all values using the
world price numeraire—both costs and benefits—will be less than their domestic price
equivalent by a fixed amount given by the SCF. Of course, it is important not to confuse the
two methods by using both the SERF and the standard conversion factor together. However, if
the shadow exchange rate factor and standard conversion factor have been consistently
estimated, that is, if one has been estimated from the other, then there will be a fixed
proportion between all costs and benefits using the two methods, and, correspondingly, the
EIRR will be the same. The choice of which numeraire to use will depend on how easily the
analysis of economic viability fits together with the analysis of financial and fiscal
sustainability.
104. The SWRF can also be expressed in both numeraires. The ratio between the economic
and financial cost of labor for different categories forms the basis of the SWRF. Where the
economic costs are measured in domestic market price values, the SWRF can be used directly
in a domestic market price analysis. Where economic viability is being measured in world
market price values, the SWRF also has to be expressed in world market price values, using a
specific or the standard conversion factor. Hence, the SWRF for domestic market price
analysis is multiplied by the specific or standard conversion factor to give the equivalent
SWRF for world market price analysis (see Appendix 15).
H. Conversion Factors
105. Conversion factors can be calculated and used when testing the economic viability of
a project. A conversion factor is the ratio between the economic price value and the financial
value for a project output or input. This ratio can be applied to the constant price financial
values in project analysis to derive the corresponding economic values. Conversion factors can
be calculated for
• specific project items, for example, the main outputs and inputs;
• groups of typical items, such as, petrochemicals or grains; and
• the economy as a whole, as in the SERF or standard conversion factor.
Specific conversion factors can be calculated to convert financial values into economic values
using the domestic market price numeraire or the world market price numeraire.
106. Where the domestic price numeraire is being used, no adjustment for economic values
is necessary for the outputs of indirectly productive projects, where an economic value has
been attributed based on the willingness to pay or the willingness to accept compensation; or
for nontraded inputs valued in the same way. For economic analysis using the world market
price numeraire, the willingness to pay or willingness to accept values should be adjusted by

the standard conversion factor to bring them in line with other items in the economic
resource flow.
107. Conversion factors for groups of products, as well as the SERF and the standard
conversion factor, are often estimated using only an adjustment for net trade taxes. This
approach generally underestimates the difference between the domestic market and border
price equivalent values. The corresponding group conversion factors are minimum estimates,
together with the SERF, using the domestic price numeraire, or maximum estimates, along
with the standard conversion factor, using the world price numeraire. Results of economic
viability analysis can be tested through higher (domestic price numeraire) or lower (world price
numeraire) values of the SERF and the standard conversion factor, respectively, and
conversion factors for groups of products.
108. Several nontraded inputs occur in nearly all projects: construction, transport, water,
power, distribution, and financial services are the most obvious. It may be desirable to
calculate specific conversion factors for these commonly occurring inputs on a country basis
so that consistent values are used across different projects in a country. Where the supply of
these nontraded inputs is being expanded, specific conversion factors can be calculated
through a cost breakdown at financial prices. The cost breakdown should include the
proportion of the financial value spent on surplus labor, scarce labor, net taxes to
government, traded items, and domestic resources. Such a cost structure can be used to
estimate a conversion factor for the item if there also exists an estimate of the SERF and
SWRFs for the different categories of labor, or a standard conversion factor and adjusted
SWRFs for the labor categories (see Table 4).
109. Table 4 illustrates the importance of two national parameters, the SERF (or standard
conversion factor) and the SWRF. The SERF and standard conversion factor are estimated at
the national level. There are different approaches to estimating a SERF/standard conversion
factor, including the use of semi-input-output methods, or an estimate of the sustainable trade
balance (see Appendix 16). The SWRF may differ from project to project for different types of
labor and should be estimated on a project basis. Moreover the opportunity cost of surplus or
scarce labor in physical terms may differ between projects—in one region it may be represented
by paddy, in another it may be represented by livestock products. Specific conversion factors
for different labor categories can also be used in the above procedure if they can be estimated.

Table 4: Specific Conversion Factors from Cost Breakdowns
Adjustment
Using Domestic Using World
Price Level Price Level
Item Proportion (%) Numeraire Numeraire
Traded goods 60 SERF 1.0
Surplus labor 10 OCSL OCSL * SCF
Scarce labor 10 OCSCL OCSCL * SCF
Net taxes 10 0.0 0.0
Domestic resources 10 1.0 SCF
Total 100 DMP adjusted WMP adjusted
Conversion Factors DMP CF WMP CF
CF - Conversion factor
DMP - Domestic market price
OCSCL - Opportunity cost of scarce labor
OCSL - Opportunity cost of surplus labor
SCF - Standard conversion factor
SERF - Shadow exchange rate factor
WMP - World market price
I. Economic Viability: A Procedure
110. In a project context, the methods outlined above need to be applied in a cost-effective
manner. The focus must be placed on those economic prices that are important for testing the
economic viability of the specific project. Economic price calculations can be carried out in
more or less detail. The following iterative procedure can be used to determine what level of
detail to pursue:
First Iteration
(i) Choose the numeraire and unit of account for the analysis.
(ii) Obtain the SERF or the standard conversion factor.
(iii) Revalue the main outputs and inputs having a trade effect at border price
equivalent values. Use a simple SERF or the standard conversion factor
estimate to bring traded/nontraded items to a common basis.
(iv) Obtain willingness to pay or other valuations for incremental nontraded
outputs.
(v) Identify any nontraded inputs that are crucial to the project and for which
financial prices incorporate a significant tax or, more likely, subsidy
element. There is likely to be only one or none for any project. Calculate
a specific conversion factor for such an item.
(vi) Estimate a SWRF for project labor.
(vii) Estimate the economic value of land using the SERF or the standard
conversion factor.

(viii) Calculate the project net present value (NPV) and internal rate of return
(IRR) using:
- border price equivalent values for the main traded
outputs and inputs;
- a willingness to pay or other estimate for incremental nontraded outputs;
- a specific conversion factor for any major, subsidized nontraded input;
- a SWRF for project labor adjusted by the standard conversion factor, if
necessary; and
- a SERF estimate for other trade items, or a standard conversion factor
estimate for other nontraded items.
(ix) Test the sensitivity of the results to the SERF or the standard conversion
factor value used, and the SWRFs used.
(x) If the project or subproject is not marginal, and if the result is not
sensitive to the national parameter estimates used, present the results of
the economic viability tests.
111. If the project or subproject is marginal, or if the results are sensitive to the national
parameter estimates used, proceed to the second iteration:
Second Iteration
(i) Estimate specific conversion factors for other nontraded inputs, labor,
and land. Sometimes these can be taken from studies of national
parameters carried out at the national level.
(ii) Reestimate the NPV and IRR of the project or subproject.
(iii) Present the results of the tests of economic viability (see Appendix 17).
VIII. LARGE PROJECTS, LINKAGES, AND NATIONAL AFFORDABILITY
112. Most projects can be treated as marginal projects in the sense that they do not have
any substantial influence on other sectors or projects. However, some large projects may have
considerable repercussions within the local and the national economy. A large project can be
seen as one that affects production levels and prices in the sector of output and in supplying
sectors. For such projects, there should be a discussion of linkage effects. A project can also be
seen as large in a national context, where it may have a substantial impact upon foreign
exchange revenues, expenditures, or budget resources, particular for Bank-financed projects in
borrowing countries with smaller population and economies. For such projects, there should
be a discussion of national affordability.
113. The linkage effects of large projects will be considerable. Where possible, a
quantitative estimate should be made of the main linkage effects. This could include

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